HM Treasury Analysis – The Immediate Economic Impact of Leaving the EU

8/16/2019 HM Treasury Analysis – The Immediate Economic Impact of Leaving the EU

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HM Treasury analysis:

the immediate economicimpact of leaving the EU

Cm 9292 May 2016


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HM Treasury analysis:

the immediate economicimpact of leaving the EU

Presented to Parliament by theChancellor of the Exchequerby Command of Her Majesty

Cm 9292

May 2016


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This document has bene tted from a review by Professor Sir Charles Bean, formerDeputy Governor of the Bank of England, acting in a personal capacity as an academicconsultant to HM Treasury. All content and conclusions in this study are, however, theresponsibility of HM Treasury.

Commenting on the work, Professor Bean said: “While there are inevitably manyuncertainties – including the prospective trading regime with the EU – this comprehensiveanalysis by HM Treasury, which employs best-practice techniques, provides reasonableestimates of the likely size of the short-term impact of a vote to leave on the UK economy.”


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ContentsForeword 3

Executive summary 5

Section 1 Uncertainty, disruption andcosts of leaving the EU 11

Section 2 Macroeconomic analysis of theimmediate impact of leavingthe EU on the UK economy 35

Annex A Macroeconomic and scal modelling of the immediate impact of the UKleaving the EU 59

Annex B Article 50 of the Treaty onEuropean Union 79

Glossary of key terms 80

List of tables 82

List of gures 82

List of charts 83

HM Treasury analysis: the immediate economic impact of leaving the EU 1


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Foreword

The decision that the British people will make in exactly one month’s time – whether toremain in the European Union or to leave it – will affect families, jobs and the future ofour country for decades to come.

I promised to set out a serious and sober assessment of the economic facts, to informthis vital decision for our country.

The Treasury document published five weeks ago set out a rigorous analysis of thelong-term impact of leaving. It showed that under any alternative relationship withEurope, we would trade less, do less business and receive less investment. Its centralestimate was that Britain would be permanently poorer by the equivalent of £4,300 per

household by 2030 and every year thereafter. Depending on the new relationship withthe EU, these long-term costs could be even larger.

This paper focuses on the immediate economic impact of a vote to leave and the twoyears that follow. Such a vote would change fundamentally not just the UK’srelationship with the EU, our largest trading partner, but also our relationship with therest of the world. The instability and uncertainty that would trigger is assessed.

The Treasury analysis in this document uses a widely-accepted modelling approachthat looks at the impact of this uncertainty and instability on financial markets,households and businesses, as our economy transitions to a worse tradingarrangement with the EU.

I am grateful to Professor Sir Charles Bean, one of our country's foremost economistsand a former Deputy Governor of the Bank of England, who has reviewed this analysisand says that it “provides reasonable estimates of the likely size of the short-termimpact of a vote to leave on the UK economy”.

The analysis in this document comes to a clear central conclusion: a vote to leavewould represent an immediate and profound shock to our economy. That shock wouldpush our economy into a recession and lead to an increase in unemployment of around500,000, GDP would be 3.6% smaller, average real wages would be lower, inflationhigher, sterling weaker, house prices would be hit and public borrowing would risecompared with a vote to remain.


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Executive summary

To inform the decision that the British people will make on whether the United Kingdom(UK) should remain a member of the European Union (EU), this document provides acomprehensive, rigorous and objective analysis of the immediate impact of a vote to leave.

An earlier HM Government document ( HM Treasury analysis: the long-term economic impact of EU membership and the alternatives ) considered the long-term economic impactof a vote to leave the EU by comparing continued membership with the alternativesdescribed in the HM Government document ( Alternatives to membership: possible modelsfor the United Kingdom outside the European Union) .1 It focused on a period of 15 yearsfollowing the referendum, by which point the nature of the UK’s future relationship with the

EU would be clear and the economy would have adjusted to the new economic reality. That document concluded that the UK would be permanently poorer if it left the EUand adopted any of these alternative relationships.

That document did not consider the disruptive, short-term adjustment that would followa vote to leave.

The analysis in this HM Treasury document quantifies the impact of that adjustmentover the immediate period of two years following a vote to leave. Such a vote wouldtrigger a redefinition not only of the UK’s economic relationship with the EU and the restof the world, but also of much of the UK’s domestic economic policy, regulatory andlegislative framework. A vote to leave would cause an immediate and profound

economic shock creating instability and uncertainty which would be compoundedby the complex and interdependent negotiations that would follow.

The central conclusion of the analysis is that the effect of this profound shock wouldbe to push the UK into recession and lead to a sharp rise in unemployment.

The scale and impact of this uncertainty and instability is analysed drawing on a widely-accepted modelling approach, used by the Bank of England and other leading institutionsand economists. A vector autoregression (VAR) model is employed to identify the impact ofincreased uncertainty on overall economic activity. This is combined with analysis of the

1 HM Treasury analysis: the long-term economic impact of EU membership and the alternatives , HM

Government (April 2016). Alternatives to membership: possible models for the United Kingdomoutside the European Union , HM Government (March 2016). The models considered are EuropeanEconomic Area (EEA) membership, a negotiated bilateral agreement with the EU, and World TradeOrganization (WTO) membership.


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6 HM Treasury analysis: the immediate economic impact of leaving the EU

effect of the initial transition to the new long-term relationship with the EU, as set out in the Treasury’s assessment, 2 and the large downward movement in asset prices that wouldensue. The impact of these effects on the economy is then quantified using a globalmacroeconomic model. This document has benefitted from a review by Professor SirCharles Bean, former Deputy Governor of the Bank of England, acting in a personal

capacity as an academic consultant to HM Treasury.

The economic impact of a vote to leave the EU The immediate economic impact would be driven by three key factors:

1 the ‘ transition effect ’: the emerging impact of the UK becoming less open totrade and investment under any alternative to EU membership

2 the ‘ uncertainty effect ’: the rise in uncertainty following the referendum andthe impact that has on economic decisions

3 the ‘ financial conditions effect ’: the extent of financial market volatility

The transition effect

HM Treasury analysis: the long-term economic impact of EU membership and the alternatives demonstrated that the UK would become less open, less productive andpoorer as a country in the long term following a vote to leave the EU.

The effect of this would start to be felt immediately. Businesses would start to reduceinvestment spending and cut jobs in the short term, consistent with lower externaldemand and investment in the future. This transition effect would also lead to lowerincomes, reducing household spending.

The scale of the initial impact of this transition to a permanent reduction in trade, foreigndirect investment and productivity in the long term would depend crucially on the sort ofrelationship the UK would seek with the EU. The analysis in the long-term documentsets out a range for each alternative, with a central estimate that gross domesticproduct (GDP) would be £4,300 lower in 2015 terms for each household after 15years and every year thereafter. 3 However, the impact of the transition effect would beconsiderably larger if the UK did not seek participation in the Single Market, as would bethe case if it fell back on World Trade Organization (WTO) membership.

The uncertainty effect

While the referendum would settle the issue of EU membership once and for all, manyaspects of the UK’s international and domestic economic policy framework would beput in doubt, leading to a significant rise in uncertainty. Businesses and householdswould respond to this by putting off spending decisions until the nature of newarrangements with the EU became clearer. This uncertainty effect would also loweroverall demand in the economy in the immediate aftermath of a vote to leave.

A large number of academic studies show a clear link between a range of uncertaintymeasures and economic activity. For this document’s analysis, a comprehensive UKuncertainty indicator was constructed. The Bank of England has also used a similarindicator to evaluate movements in uncertainty.

2 HM Treasury analysis: the long-term economic impact of EU membership and the alternatives , HMGovernment (April 2016).

3 Ibid.


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The extent and duration of the uncertainty created would depend on the progress madein negotiations with the EU and other international partners which would be inherentlyuncertain. Four processes would need to be completed:

Process 1: agreeing the UK’s terms of withdrawal from the EU under Article 50of the Treaty on European Union

Process 2: agreeing the UK’s new trading relationship with the EU Process 3: agreeing the UK’s new trading relationships with the rest of the

world including over 50 countries with which the UK would need to negotiatenew trade arrangements

Process 4: changing the UK’s domestic regulatory and legislative framework

Each of these four processes would be complicated in their own right, butconducting them all at the same time, on any terms that would be acceptable tothe UK and within the specified two-year period for leaving the EU would almostcertainly be impossible. If these processes were more protracted, the uncertaintywould be larger and, as set out in a previous HM Government document, could last upto a decade or more. 4

Moreover, there would be a trade-off between securing a deal as quickly as possible toreduce uncertainty in the short-term, and securing the best possible deal for the UK tominimise the economic costs of exit over the long term. Even then, it would not bepossible to provide the clarity required to address uncertainty in the short term, as thatwould require anticipating the outcomes of negotiations with other nations andParliamentary votes that would be inherently uncertain up to the point they wereconcluded, and over which the UK would not have full control. A period of persistentuncertainty about the UK’s economic policy, regulatory and legislative regime in theevent of a decision to leave the EU would therefore be unavoidable.

The financial conditions effect

Both the uncertainty effect and the transition effect would in turn weigh on financialmarkets, increasing volatility. Asset price falls would lead to this financial conditionseffect amplifying the uncertainty and transition effects.

In the immediate aftermath of a vote to leave, financial markets would start to reassessthe UK’s economic prospects. The UK would be viewed as a bigger risk to overseasinvestors, which would immediately lead to an increase in the premium for lending to UKbusinesses and households. The value of UK personal investments would also decline,and the fall in the value of the pound would put upward pressure on the prices paid byconsumers. This would add to the transition and uncertainty effects and influence awide range of financial conditions facing businesses and households.

Through a combination of these three effects, a vote to leave the EU would havea damaging effect on both the demand side and supply side of the economy . Twoscenarios have been modelled to provide analysis of the adverse impact on theeconomy: a ‘shock’ to the economy and a ‘severe shock’.

The impact in advance of the referendumEvidence for these effects is already clear in advance of the referendum . Infinancial markets, the value of the pound has fallen and the price financial market

4 The process for withdrawing from the European Union , HM Government (February 2016).


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participants are prepared to pay for insurance against default on UK government debthas increased markedly.

For the wider economy, recent survey data shows weaker expectations for businessinvestment, and there has been a sharp fall in commercial real estate transactions.Consistent with this, the Purchasing Managers Indices for services, manufacturing andconstruction output are all at their lowest levels for three years.

The Bank of England’s Monetary Policy Committee (MPC) expects growth to slow in2016 Q2. At its May 2016 meeting, the MPC noted that “there are increasing signs thatuncertainty associated with the EU referendum has begun to weigh on activity”. 5

The impact of a vote to leave the EU: shock scenarioIn the shock scenario, many of the assumptions underlying the interaction of the threeeffects of a vote to leave the EU are cautious. The size of the transition effect is linked tothe central estimate of the negotiated bilateral agreement alternative, as set out in thelong-term document. The shock scenario assumes that a vote to leave would generatea rise in uncertainty from current levels, in line with historical experience, to just belowthe peak of uncertainty experienced during the early 1990s recession; and it assumes afinancial conditions effect similar in scale.

In the shock scenario, a vote to leave would result in a recession, a spike in inflationand a rise in unemployment. The analysis shows that the economy would fall intorecession with four quarters of negative growth. After two years, GDP would bearound 3.6% lower in the shock scenario compared with a vote to remain. In thisscenario, the analysis shows that the fall in the value of the pound would be around12%, and unemployment would increase by around 500,000, with all regionsexperiencing a rise in the number of people out of work. The exchange-rate-drivenincrease in the price of imports would lead to a material increase in prices, with theCPI inflation rate higher by 2.3 percentage points after a year.

The Bank of England and International Monetary Fund (IMF) have both reported thepossibility of such a recession following a vote to leave. As the Governor of the Bank ofEngland said, “there’s a range of possible scenarios […] which could possibly include atechnical recession”; 6 and Christine Lagarde, Managing Director of the IMF, noted that sheshared the Bank of England’s view that a vote to leave the EU “could lead to a recession”. 7

The impact of a vote to leave the EU: severe shock scenario The ‘severe shock’ scenario explores the risk that the rise in uncertainty, the effect onfinancial conditions and the transition effects are larger. The rise in both uncertainty andfinancial market volatility is around 50% larger than in the shock scenario, but still onlyhalf of that seen during the financial crisis in 2008 and 2009. The size of the transitioneffect is linked to the estimate of leaving the Single Market and defaulting to WTOmembership. In the severe shock scenario, the analysis shows that after two yearsthe level of GDP would be 6% lower, the number of people unemployed would

5 Minutes of the Monetary Policy Committee meeting ending on 13 May 2016 , Bank of England(May 2016).

6 Mark Carney, Governor of the Bank of England, Inflation Report Press Conference (May 2016).7 Christine Lagarde, IMF Managing Director, Press conference for the IMF UK Article IV concluding

statement (May 2016).


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rise by around 800,000, sterling would depreciate by 15% and CPI inflation wouldincrease by 2.7 percentage points after a year.

While more severe, this scenario represents a credible risk. The larger uncertainty effectcould reflect a more protracted process for exit; while the larger transition effect linkedto WTO membership could reflect a decision to be outside the Single Market as hasbeen suggested in recent weeks.

There are significant downside risks which imply that the impact could be evenlarger . First, these scenarios do not allow for so-called ‘tipping points’, such as thecrystallisation of financial stability risks. Nor do they incorporate the risk of a ‘sudden stop’in financial inflows, reflecting concerns about the size of the current account deficit.

Nor has the impact of a sharp tightening of fiscal and monetary policy to restore credibilitybeen modelled. In both scenarios monetary policy is held fixed. Fiscal policy is assumedto support the economy through the operation of the ‘automatic stabilisers’. The analysisdoes not make any assumption about what policy decisions might be taken to contain

the resulting increase in borrowing, but these would need to be significant as netgovernment borrowing would increase by around £24 billion in the shock scenario, andby around £39 billion in the severe shock scenario, compared with a vote to remain.

Moreover, if negotiations took longer than two years to conclude, or if the outcome wereto be less favourable than expected, the UK economy could be subject to repeated andpersistent rises in uncertainty which would depress further economic prospects.

Immediate impact of a vote to leave the EU on the UK (% difference from base level unless specified otherwise)

Shock scenario a Severe shock scenario a

GDP -3.6% -6.0%CPI inflation rate (percentage points) +2.3 +2.7

Unemployment rate (percentage points) +1.6 +2.4

Unemployment (level) +520,000 +820,000

Average real wages -2.8% -4.0%

House prices -10% -18%

Sterling exchange rate index -12% -15%

Public sector net borrowing (£ billion) b +£24 billion +£39 billion

a Peak impact over two years. Unemployment level rounded to the nearest 10,000. b Fiscal year 2017-18.

In conclusion, the analysis in this document shows that a vote to leave the EU wouldresult in a marked deterioration in economic prosperity and security . This is based ona widely-accepted approach, and is supported by the effects of uncertainty already evidentin financial markets and the real economy. A recession would be expected to follow even inthe more cautious scenario with a significant risk that the outcome could be far worse.

In contrast, a vote to remain in the EU would see uncertainty fall back rapidly with littlelasting impact on the economy. Indeed, conditioned on a vote to remain, the MPCexpect growth to start to recover in the second half of 2016. 8 This would be consistent

8 Inflation Report May 2016 , Bank of England (2016).


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with the pickup in GDP seen following large uncertainty shocks, such as during thefinancial crisis in 2008 and 2009.


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Section 1Uncertainty, disruption and costs ofleaving the EU

Part 1: Introduction

1.1 A previous government paper HM Treasury analysis: the long-term economic impact of EU membership and the alternatives (“the long-term document”) looked at theimpact of leaving the European Union (EU) on the United Kingdom (UK) economy after15 years. 1 It considered the alternative models and concluded that in all of them the UKeconomy would be less open and productive. 2 It set out a range for each alternative anda central estimate that UK Gross Domestic Product (GDP) would be £4,300 lower in

2015 terms for each household after 15 years. 1.2 The long-term document did not consider the immediate economic shock of avote to leave the EU. This document looks at the immediate effect from the point of adecision to two years later, as this is the period in which to negotiate a withdrawalagreement to leave the EU as set out in the Treaties.

1.3 There are three main effects on the economy which would follow a vote to leavethe EU. These effects would have a negative impact on the economy, both in terms ofsupply and demand.

1.4 The first effect of a vote to leave the EU would be that businesses andhouseholds would start to make decisions consistent with the transition tobecoming permanently poorer in the long term. This would be defined by the UK’snew long-term trading relationship with the EU and non-EU countries, and theprospects of lower future incomes and living standards that leaving the EU would meanfor the UK, as set out in the long-term document. This effect would be larger if the UKwere not to seek participation in the Single Market, as businesses and householdswould expect an even poorer economic future.

1 HM Treasury analysis: the long-term economic impact of EU membership and the alternatives , HM

Government (April 2016).2 Alternatives to membership: possible models for the United Kingdom outside the European Union , HMGovernment (March 2016). The models considered are European Economic Area (EEA) membership, anegotiated bilateral agreement with the EU, and World Trade Organization (WTO) membership.


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1.5 Businesses and households would start to adjust immediately following a vote toleave the EU. Businesses would reduce investment spending, such as the purchase ofnew machinery and moving to new premises. They would also cut jobs, consistent withlower expectations of external demand and financial investment, including fromoverseas, in the future. Individuals would adjust their purchases of major items,

particularly where they involved extra borrowing, on the basis of lower future incomes.1.6 The second effect would be from immediate and ongoing uncertainty aboutwhat the UK’s new relationships would mean in practice and how that wouldaffect businesses and households. 3 Many of the UK’s relationships with the EU andnon-EU countries, along with large parts of the UK’s domestic regulatory frameworkwould be put in doubt. As the impact of the process of leaving the EU would beginstraight away following a vote to leave, this uncertainty effect would follow from theresult of the referendum. The process is set out in detail in Part 3.

1.7 Businesses would delay making decisions on some projects, such as thedevelopment and launch of products, or entry into new markets where the costs ofdoing business may be unclear. Individuals would postpone or scale back theirspending as they waited for conditions to become clearer, lowering overall demand inthe economy. 4 The negative economic reaction to uncertainty has been set out in thework of Professor Nicholas Bloom and others. 5

1.8 The third effect would be seen in financial conditions where markets wouldreassess the UK’s economic prospects immediately. This would start straight after avote to leave the EU was known and add to the transition and uncertainty effects.

1.9 This effect would weigh on financial markets, increasing volatility and adding to thefall in asset prices. 6 The Bank of England has said that, following a vote to leave the EU,“it is likely that sterling would depreciate further, perhaps sharply.” 7 The UK would beviewed as a bigger risk to overseas investors, who would immediately increase thepremium they charge for lending to UK businesses and households. Financial markets(for example the corporate bond market that many larger companies rely on for funding)may become less liquid as investors seek safer places for their money.

1.10 The deterioration in financial conditions would have a negative impact onbusinesses and households. Asset prices, including house and equity prices, would fallas investors would probably require higher rates of return as compensation forincreased uncertainty and the worse economic outlook. The greater risk premiarequired by investors would increase the cost of raising finance, which would be passedon through higher interest rates on borrowing by businesses and households. The valueof UK personal investments would also decline, and the fall in the value of the pound

3 Elevated uncertainty restrained economic growth in the UK during its recovery from the 2008financial crisis. Macroeconomic uncertainty: what is it, how can we measure it and why does it

matter? Haddow, Hare, Hooley and Shakir (2013). The impact of uncertainty shocks on the UKeconomy, Denis and Kannan (2013).

4 Increased risks to income levels are associated with higher rates of saving, lowering consumption.Financial Expectations, Consumption and Saving: A Microeconomic analysis , Brown and Taylor (2006).

5 The impact of uncertainty shocks , Bloom (2009).6 Policy uncertainty is associated with higher risk premia and more correlated and more volatile stock

prices. Political uncertainty and risk premia , Pastor and Veronesi (2011).7 Inflation Report May 2016 , Bank of England (2016).


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would put upward pressure on the prices paid by consumers. Larger asset price fallswould amplify the uncertainty and transition effects described above.

1.11 The effects of uncertainty on spending decisions can be long-lasting even afterthe uncertainty recedes. The Bank of England has said “it can take time for companiesand households to reassess their spending decisions and restart spending projectsafter a period of increased uncertainty.” 8

1.12 HM Treasury has compiled a composite measure of uncertainty that bringstogether measures of policy, business and consumer uncertainty, equity market andexchange rate volatility, and labour market expectations. This approach is consistentwith those used by the Bank of England and other leading institutions and economists. 9 Chart 1.A shows that periods of increased uncertainty have been associated withlower GDP growth. 10

Chart 1.A UK GDP growth and uncertainty

Source: Office for National Statistics, HM Treasury calculations

1.13 There are signs that these effects are already being seen in the economy on the

basis of the possibility of a vote to leave the EU. These effects are set out in Part 2 ofthis section.

1.14 The disruption to economic activity following a vote to leave the EU could beprolonged, as the UK’s new economic reality would depend on the outcome ofnegotiations with the EU and other international partners. As set out in the HMGovernment paper, The process for withdrawing from the European Union , a vote to

8 Inflation Report May 2016 , Bank of England (2016).9 Macroeconomic uncertainty: what is it, how can we measure it and why does it matter? Haddow,

Hare, Hooley and Shakir (2013).10 The chart uses the HM Treasury derived indicator of uncertainty, which is inverted to show therelationship with GDP growth. The uncertainty indicator is the mean of a number of direct measuresof uncertainty. Further detail is set out in Annex A.

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Box 1.A Impact of a decision to leave the EU on the agricultural sector

A vote to leave the EU would affect the agricultural sector through a numberof channels.

There would be major uncertainty about the future levels of agricultural subsidiesand whether they would be maintained at their current levels once the UK left theEU. Indeed, the Department for Environment, Food and Rural Affairs has seensignificant real terms cuts in each of its last three spending settlements.

There would also be uncertainty over the level of trade barriers between the UKand foreign agricultural markets. The EU accounts for over 60% of UK agri-foodexports, 14 so the significant risk of higher trade barriers into the EU would be aserious concern for the sector. At the same time, the level at which the UKdecides to set import tariffs would affect the degree of protection for UK farmersfrom global competition compared to the level of protection in the EU. The

livestock sector, where tariffs are generally much higher than the arable sector(equivalent to over 70% on some sorts of meat 15 ), would expect to be affectedmost by changes to trade policy.

This uncertainty could have a depressing impact on agricultural rents and landprices. Farmers and landowners could be expected to delay purchases ofmachinery and other forms of investment, until there is greater clarity on the levelsof subsidy and tariffs.

The National Farmers Union Council have resolved that “the interests of farmersare best served by our continuing membership of the European Union.” 16

14 Department for Environment, Food and Rural Affairs (Defra) calculations based on HM Revenue andCustoms data (2014).

15 Defra calculations of effective tariff rates based on HMRC trade data.16 EU Referendum Where do WE stand, National Farmers’ Union (2016).


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Part 2: The economic impact inadvance of the referendum

1.18 The evidence for the negative economic effects described in Part 1 isalready clear in advance of the referendum. Sterling has weakened and businessexpectations and investment intentions have declined. 17 The Bank of England’s MonetaryPolicy Committee (MPC) has said that “there are increasing signs that uncertaintyassociated with the EU referendum has begun to weigh on activity.” 18 The InternationalMonetary Fund (IMF) has said that uncertainty and implications of a potential vote to leave“already appears to be having an impact on investment and hiring decisions.” 19 TheOrganisation for Economic Co-operation and Development (OECD) has said that“uncertainty about the referendum has begun to hold back UK growth.” 20

1.19 The negative impact of uncertainty that is currently affecting the economy reflectsthe assessment of the possibility of a vote to leave. There would be a profoundeconomic shock if leaving the EU became a certainty when the referendum decisionwas known.

1.20 This Part sets out the recent developments in a series of financial and non-financial indicators. These are mainly UK measures and are likely to capture concernsdriven by the uncertainty over the potential for a vote to leave the EU more than widerconcerns about the global economy.

Impact of a possible vote to leave the EU on financial indicators1.21 As financial markets are forward looking and are affected by the full distributionof outcomes, they have started to put some weight on, or ‘price-in’, a vote to leave indetermining asset prices in advance of the referendum.

1.22 Sterling depreciated by around 7% from its peak in November 2015 on a trade-weighted basis. 21 The Bank of England has estimated that, by mid-May, “roughly half ofthat decline reflects perceived risks associated with the referendum on UK membershipof the European Union.” 22 Exchange rates should move in line with changes in thedifference between interest rates which can be earned in different currencies. This isknown as the ‘uncovered interest rate parity condition’. Sterling has depreciated bymore than changes in UK interest rates relative to other countries would imply (Chart1.B). This suggests an additional risk premium in sterling has become evident, whichmay reflect referendum uncertainty. The chart shows the trade-weighted sterlingexchange rate and a weighted average of relative interest rates between the UK and itsmain trading partners.

17 UK Purchasing Managers Index , Markit/Chartered Institute of Procurement and Supply (CIPS) (May2016); Agents’ summary of business conditions, Bank of England (May 2016); and ManufacturingOutlook Quarter 1, EEF (2016).

18 Monetary Policy Summary and minutes of the Monetary Policy Committee meeting ending on 11May 2016 , Bank of England (2016).

19 United Kingdom – 2016 Article IV Consultation Concluding Statement of the Mission, IMF (2016).20 The Economic Consequences of Brexit: A Taxing Decision , OECD (2016).21 Sterling trade-weighted exchange rate index (ERI), Bank of England (as at 20 May 2016).22 Inflation Report May 2016 , Bank of England (2016).


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Chart 1.B – Sterling trade-weighted exchange rate index (ERI) and weightedrelative interest rates

Source: Bank of England, Bloomberg, HM Treasury calculations*The weighted relative interest rate is the difference between UK 2-year interest rates and a weighted

average of other countries’ 2-year interest rates, with the weights equal to each currency’s weight inthe sterling ERI

1.23 Consistent with a rise in perceived risk, sterling exchange rate volatility hasincreased significantly in recent months. Implied exchange rate volatility reflects theprice financial market participants are prepared to pay to insure against futuremovements in foreign exchange prices. An increase in volatility reflects greateruncertainty over the future value of sterling. The volatility implied from options to buy orsell sterling in two months’ time, therefore settling after the referendum date, rosesignificantly after 23 April, the date two months before the referendum. It reached itshighest level since March 2009 on 16 May 2016 (Chart 1.C). 23

1.24 There have been signs of heightened volatility in UK equity markets, which mayalso reflect uncertainty over the referendum. The implied volatility of the FTSE 100 indexreflects the cost to market participants of insuring against moves in the index and isimplied from options to buy or sell the stocks and shares which make up the index.Implied volatility for the FTSE 100 has risen by more than for the US S&P 500 stockmarket index for options that expire around the date of the referendum, with thedifference reaching its highest level since the series began in 2010. 24

23 2-month sterling-dollar option implied volatility data series, Bloomberg (as at 20 May 2016).24 2-month FTSE 100 and S&P 500 at-the-money option implied volatility data series, Bloomberg (as at

20 May 2016).

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Chart 1.C: 2-month ahead Sterling, Euro and Yen implied volatility against theUS dollar (%)

Source: Bloomberg

1.25 UK sovereign credit default swaps (CDS) are financial instruments that provideinsurance against the government failing to make payments on gilts. Movements in UKCDS have in recent years been aligned with the US and Germany. The cost ofprotection against UK risks has been rising since November 2015, more so than for theUS and Germany, (Chart 1.D). As the OECD has noted, this rise reflects investors’ fears

of the macroeconomic risks and uncertainty that would be associated with a vote toleave the EU. 25

25 The economic consequences of Brexit , OECD (2016).

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Chart 1.D: Sovereign credit default swap spreads (index, 1 November2015=100)

Source: Bloomberg

Impact on non-financial indicators1.26 Uncertainty is having an impact on investment decisions. The Deloitte survey ofChief Financial Officers (CFO) in April (Chart 1.E) showed a sharp increase in the numberof CFOs who rate the level of external financial and economic uncertainty facing their

business as above normal, high or very high.26

Survey participants cited the possibility ofa vote to leave the EU as the biggest risk to their business.

1.27 CFOs expect capital expenditure to fall in the next 12 months (Chart 1.E). 27 Riskappetite has also suffered from the rising uncertainty with the proportion of CFOs sayingthat now is a good time to take risk dropping from 51% to 25% in the past year.

26 Brexit tops CFO risk list: Deloitte CFO Survey: 2016 Q1, Deloitte (2016).27 Ibid.

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Chart 1.E: Expectations of UK capital expenditure and uncertainty

Source: Chief Financial Officer Survey, Deloitte

1.28 Other indicators of investment intentions have weakened. The May 2016 Bank ofEngland Agents’ summary of business conditions showed that “there was some evidenceof businesses delaying investment expenditure decisions on account of uncertaintyaround the outcome of the EU referendum.” 28 The latest survey from EEF, themanufacturers’ organisation, showed a decline in investment intentions amongmanufacturers. 29 The survey found that firms have muted appetite to increase investment

and jobs. Chart 1.F shows the recent weakness in investment intentions in both surveys.1.29 UK GDP growth fell from 0.6% in 2015 Q4 to 0.4% in 2016 Q1. 30 The key driverof the slowing of GDP growth was Business and Finance services, which grew by 0.3%in 2016 Q1, less than half of the 0.7% growth in 2015 Q4. 31 Business and Financeservices account for over 30% of GDP. The Bank of England has noted that some ofthe slowdown in business services growth may have reflected uncertainty surrounding apossible vote to leave the EU. 32

28 Agents’ summary of business conditions, Bank of England (May 2016).29 Manufacturing Outlook Quarter 1, EEF (2016).30 Gross domestic product preliminary estimate: January to March 2016 , Office for National Statistics

(2016).31 Ibid.32 Inflation Report May 2016, Bank of England (2016).

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Chart 1.F: Investment intentions over the next 12 months

Source: Bank of England Agents’ summary of business conditions, EEF

1.30 The risk of leaving the EU is also having an effect on other economic indicators. The latest Purchasing Managers Indices (PMI) for April 2016 suggest a worseningoutlook for businesses across the economy in recent months, (Chart 1.G, where ascore below 50 indicates a contraction). 33 Respondents reporting a slowdown in neworders cited increased uncertainty from the potential vote to leave in the referendum.Growth in the construction sector eased, with a sharp slowing in new orders linked to

uncertainty, as respondents cited a general unwillingness to commit to new projects.1.31 The PMIs provide a good guide to economic activity. If the weaker PMI scores wereto persist, they could be associated with lower GDP growth. The Bank of England projectsthat GDP growth will slow to 0.3% in 2016 Q2, compared with 0.4% in 2016 Q1. 34

33 UK Services PMI, UK Construction PMI, and UK Manufacturing PMI, all Markit/CIPS (May 2016).34 Inflation Report May 2016, Bank of England (2016).

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Chart 1.G: UK Purchasing Managers Index (balance, over 50 = expansion)

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1.32 There are signs that the risk of leaving the EU is affecting the labour market. TheRecruitment and Employment Confederation have reported that “employers are turningto temps and contractors to provide a flexible resource, as a way of hedging anypossible change to the UK’s relationship with Europe, and the implications this wouldhave for the economy.” 35

1.33 Uncertainty also appears to be having a negative effect on commercial property. The MPC has noted that transactions in commercial real estate had fallen by nearly40% in 2016 Q1. 36 Latest figures from the 2016 Q1 UK Commercial Property MarketSurvey from the Royal Institution of Chartered Surveyors (RICS) show that demand forUK commercial property among international investors is starting to slow (Chart 1.H). 37

A large number of respondents felt uncertainty about the possible vote to leave the EUwas reducing investment in the commercial property market, particularly in London,where 80% felt that doubt over the UK’s future position in the EU was weighing oninvestment. In addition, 43% of respondents considered a vote to leave the EU wouldcarry negative consequences for commercial real estate, while only 6% felt it would bepositive in the long term.

1.34 Short-term expectations for growth in house prices have been declining steadilyin 2016. RICS have highlighted this may reflect the uncertainty that the possibility of avote to leave the EU is having on the housing market. Its latest survey shows only 5%more surveyors expect prices to increase rather than fall in the next three months. Thisis a significant reduction in expectations since December 2015, when 44% moresurveyors expected prices to increase rather than fall (Chart 1.H). 38

35 Report on Jobs¸ Recruitment and Employment Confederation (May 2016).36 Monetary Policy Summary and minutes of the Monetary Policy Committee meeting ending on 11

May 2016 , Bank of England (2016).37 2016 Q1: UK Commercial Property Market Survey , RICS (2016).38 UK Residential Market Survey, RICS (April 2016).

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Chart 1.H Property indicators

Source: Royal Institution of Chartered Surveyors

1.35 The Bank of England has noted that if the UK votes to remain in the EU, therecent weakness in GDP is “projected to unwind over subsequent quarters.” 39 Thiswould be consistent with previous periods in which uncertainty rose sharply, such asthe financial crisis in 2008 and 2009. Business expectations of future growth have beenlinked to a number of factors including a vote to remain in the EU. 40 The IMF has alsosaid “in the event of a vote to remain in the EU, growth is expected to rebound during

the second half of the year.”41

1.36 A vote to leave the EU would, however, lead to a sharp further increase inuncertainty and instability, and have negative effects on investment as well asbusiness and consumer confidence. This is likely to happen because the effects thathave already been observed are those only in response to the possibility of a vote to leavethe EU. Section 2 analyses the expected economic impact of an actual vote to leave.

39 Inflation Report, May 2016 , Bank of England (May 2016).40

“Where companies predicted growth of output over the forthcoming outlook period, this was linkedto business expansion, marketing, new product launches, demand from the construction sector anda ‘remain’ vote in the forthcoming EU referendum”, UK Services PMI , Markit/CIPS (May 2016).

41 United Kingdom – 2016 Article IV Consultation Concluding Statement of the Mission, IMF (2016).

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Part 3: Sources of instability followinga vote to leave the EU

1.37 The transition effect described in Part 1 for businesses and households to adjustto the new, lower long-term level of GDP would be exacerbated by the uncertainty ofthe process of leaving the EU. No member state has ever left the EU, so the processwould be unprecedented.

1.38 There are four complex and interdependent processes which would need to becompleted in order to resolve fundamental questions about the UK’s long-termeconomic policies:

Process 1: agreeing the UK’s terms of withdrawal from the EU under Article 50of the Treaty on European Union (TEU) – the full text of Article 50 can be found

at Annex B Process 2: agreeing the UK’s new trading relationship with the EU Process 3: agreeing the UK’s new trading relationships with the rest of the world,

including over 50 countries with which the EU has an existing trade arrangement Process 4: changing the UK’s domestic economic policy, regulatory and

legislative framework

1.39 As set out in a previous HM Government document, The process forwithdrawing from the European Union, it is probable that it would take an extendedperiod to complete these processes on any terms that would be acceptable. A vote to

leave the EU therefore would be the start, not the end of these processes. Thesecould exacerbate and extend the uncertainty effect described above, and lead toup to a decade or more of uncertainty. 42

1.40 As the Managing Director of the IMF has said, “Negotiations on newarrangements with the European Union and other trading partners could in our viewtake years, leading to a protracted period of uncertainty, and the longer this uncertaintygoes on the more heavily it will weigh on investment and growth.” 43

Process 1: Agreeing the UK’s terms of withdrawal from the EU

1.41 The rules for exit are set out in Article 50 of the TEU. This is the only lawful wayto withdraw from the EU. It would be a breach of international and EU law to withdrawunilaterally from the EU (for example, by simply repealing the domestic legislation thatgives the EU law effect in the UK). Article 50 has never been tested and there isuncertainty about how it would work. It would be a complex negotiation requiring theinvolvement of all remaining 27 EU member states and the European Commission. Itwould mean unravelling all the rights and obligations that the UK has acquired during itsaccession to the EU and over 40 years of membership. Figure 1.A sets out the process.

42 The process for withdrawing from the European Union , HM Government (February 2016).43 Christine Lagarde, IMF Managing Director , Press conference for the IMF Article IV concluding

statement (May 2016).


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1.42 The Prime Minister has said that if the UK votes to leave the EU, the Britishpeople would expect the Article 50 process to start straight away. 44 Article 50 providesfor a two-year negotiation to agree a withdrawal agreement that would requireenhanced qualified majority approval from the remaining 27 member states andthe support of the European Parliament. 45 An extension to the two-year deadline

would require the unanimous agreement of all 27 remaining member states. Withoutsuch an extension, if after two years no deal were reached, exit from the EU would takeplace automatically.

Process 2: Agreeing the UK’s new trading relationship with the EU

1.43 Article 50 is unclear about how far the arrangements for the UK’s newrelationship with the EU would be included in a withdrawal agreement. It is likelyhowever that the scope of those arrangements would require the negotiation of aseparate agreement with the EU.

1.44 The precise process for negotiating that agreement would depend on itscontent, but an ambitious agreement could need the unanimous agreement of all 27member states in the Council. Any such process would clearly add to the complexity,and hence, very probably, to the length of the overall negotiations. If the agreementneeded unanimous support in the Council, it would be open to any member state toseek to block it, or to extract a price for agreeing any element of the agreement. 46

1.45 The HM Government paper Alternatives to membership: possible models for theUK outside the EU , set out the existing alternative relationships with the EU:membership of the European Economic Area (EEA); a negotiated bilateral agreement; orWorld Trade Organization (WTO) membership without any form of special agreementwith the EU. 47 The long-term document demonstrated that these alternatives would

leave the UK permanently poorer compared to remaining a member of the EU. It foundthat alternatives that involve retaining significant access to the Single Marketfor trade would require accepting EU regulations the free movement ofpeople and financial contributions to the EU without any say over EUdecision making. The long-term document also showed that relying on WTOmembership would be the worst economic alternative for the UK.

44 Prime Minister’s Statement on the European Council , Hansard (22 February 2016).45 Article 50 of the Treaty on European Union stipulates that the voting rule to be used is that set out in

Article 238(3)(b) of the Treaty on the Functioning of the European Union, which requires 72% ofmember states (i.e. 20 out of the remaining 27 member states) comprising 65% of the EU population.

46 The process for withdrawing from the European Union , HM Government (February 2016).47 Alternatives to membership: possible models for the United Kingdom outside the European Union ,

HM Government (March 2016).


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Figure 1.A: Process 1 for withdrawal from the EU and Process 2 for the newtrading relationship with the EU

Source: The process for withdrawing from the European Union, HM Government, (February 2016)


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Box 1.B Impact of a decision to leave the EU on the aviation andmaritime sectors

A vote to leave the EU would cause significant disruption to the UK’s aviation andmaritime sectors. 125,000 jobs are directly supported by the UK’s aviationsector, 48 and 113,000 people work in the maritime industry. 49

EU initiatives to open up markets to competition and common regulation acrossthe Single Market have reduced costs for businesses. 50 Following a vote to leave,there would be uncertainty over businesses’ access to the Single Market and therules with which they would need to comply.

The Single Market for aviation has opened up the EU’s aviation market tocompetition and allowed UK-based airlines to operate any intra-EU route, bringinggreater choice and lower prices. Following a vote to leave the EU there would beuncertainty over airlines’ access to other EU countries. If UK-based airlines lost

routes into the EU then UK passengers would face reduced choice overdestinations. The number of intra-EU routes has more than doubled since 1993. 51

Even if not bound by EU legislation in the UK, the inherently cross-border nature ofthe sector means UK-based businesses would need to comply with EU ruleswhen flying to EU destinations, for example by ensuring they were sufficientlyequipped to operate in other states’ airspace. In practice, implementing differentregulations in the UK would create extra costs for the airline industry, puttingpressure on fares.

The cross-border nature of shipping means differences in regulation would alsodirectly raise costs for businesses. Leaving the EU would create uncertainty over

the extent to which EU rules would apply to UK shipping. The nature of the sectormeans it would be heavily exposed to the negative impact on trade that leavingthe EU would imply.

In order to continue trading across the Single Market, businesses would have toweigh up the costs of continuing their current business models, or restructurethemselves, including by locating in the remaining EU. Given the high proportion oftheir business that is focussed on the EU, the incentive to relocate activities and

jobs to the remaining EU would be strong.


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Process 3: Agreeing the UK’s new trading relationships with the rest of the world

1.46 On leaving the EU, in addition to losing its current access to the EU Single Market,the UK would no longer benefit from the EU’s free trade agreements with the rest of theworld. The UK currently benefits from such agreements with over 50 countries, andwould benefit from the successful conclusion of agreements with a further 67 countriescurrently under negotiation, including the US, Japan and India. 52 The UK would need todecide how to go about replacing these trading relationships.

1.47 The UK would also need to update the terms of its WTO membership where thecommitments have previously applied to the EU as a whole. This would meannegotiating and agreeing updated UK schedules of commitments with all 161 otherWTO members. Until the UK’s schedule of commitments was updated, there could bequestions surrounding the UK’s rights to access WTO members’ markets, and the UK’sability to enforce those rights.

1.48 The UK would want to start negotiations as soon as possible with non-EU trade

partners in particular, in order to preserve any existing level of preferential access UKbusinesses currently get to those markets. However, many of the UK’s non-EU tradingpartners are already negotiating with the EU, and before they were to begin negotiationswith the UK they would be likely to want those deals with the EU to conclude. It wouldtherefore be hard to negotiate the new trading relationship with the EU in parallelwith negotiating a new set of trade deals with the countries outside the EU.

1.49 There would be significant uncertainty about whether it would be possible for theUK to reach agreements that replace the benefits to UK businesses of the EU’s tradeagreements and how long it would take to reach all of these agreements. This couldhave a prolonged effect on businesses who would be unsure of their ability to trade onexisting terms. As set out in the long-term document, the UK is unlikely to secureaccess to wider global markets as good as it has through the EU. Against a trendtowards regional deals such as the Transatlantic Trade and Investment Partnership 53 and the Trans-Pacific Partnership, the UK would have less ability to negotiate beneficialdeals than it currently does as part of a large bloc (the EU’s economic weight is fivetimes that of the UK). 54 As Pascal Lamy, the former Director General of the WTO, hassaid, “to fall back on WTO rules…would be a terrible replacement for access to the EUSingle Market.” 55

48 Annual business survey, Office for National Statistics (2014).49 Maritime Growth Study , Department for Transport (2015).50 HM Treasury analysis: the long-term economic impact of EU membership and the alternatives , HM

Government (April 2016).51 20 years of the single market , European Commission (2012).52 European Commission (2016).53 The Transatlantic Trade and Investment Partnership is currently being negotiated between the US

and the 28 EU member states. The Trans-Pacific Partnership comprises 12 countries of the PacificRim, including the US, Japan, Canada and Australia.

54 World Economic Outlook, IMF (April 2016).55 Britain won’t get better trade deals if it leaves Europe, The Times (3 May 2016).


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Box 1.C Impact of a decision to leave the EU on selected advancedmanufacturing sectors

Aerospace

The UK is a world leader in civil aerospace – number one in Europe and secondonly to the US globally 56 – employing 110,000 people 57 and supporting a further113,000 jobs. 58 It relies heavily on EU supply chains, both as a buyer and a seller,and even companies that do not directly export produce parts for other exporters.In the UK, Airbus designs and manufactures wings and Rolls-Royce makeengines, but many of the aircraft that end-users buy are assembled in continentalEurope. Aerospace is an international industry.

A vote to leave the EU would result in uncertainty over continued access to thesesupply chains. Businesses would want to ensure supply chains could continue todeliver after UK exit from the EU, but the uncertainty could lead businesses to

make decisions to invest and source components away from the UK immediatelyfollowing a vote to leave.

Reflecting these risks, 76% of aerospace members of ADS (the trade associationwhich covers Aerospace, Defence, Security and Space sectors) believe remainingin the EU is best for their business. 59 Indeed, Airbus Group UK recently warnedthat their investment would be less certain if the UK votes to leave. 60 This wouldeventually undermine the UK’s manufacturing capability and make it less likely theUK attracts future work when new aircraft models are launched.

There would also be some uncertainty over the rules under which UK-basedbusinesses would need to operate. That said, many decisions affecting the UK

aerospace sector would still be made outside the UK. Regulations negotiatedthrough the EU (for example, on emissions and noise) would in practice still beapplied by UK businesses that wanted to continue trading internationally, but theUK would have less influence over Europe-wide negotiating positions.

Aerospace is a rapidly developing industry and sustained investment intechnology, design and production is critical for the high productivity of the sector.

A temporary decline in investment could permanently affect the continuedcompetitiveness of the sector.

Automotive

The UK is the fourth largest vehicle manufacturer in Europe, making 1.6 millionvehicles a year, 61 and is particularly international – nearly four in every five UK-made vehicles are exported, with almost 60% of those going to the EU. 62 Thesector directly supports 147,000 jobs, with another 300,000 in the supply chain. 63 It relies heavily on international supply chains, both through selling UK goodsabroad and through using overseas components in UK products.

A vote to leave the EU would create uncertainty about the UK’s continued accessto the Single Market. These international supply chains would look vulnerable.Highlighting these concerns, 77% of the members of the Society of MotorManufacturers and Traders (SMMT), which covers the automotive sector, say thebest outcome for their business is a vote to remain. 64 These worries reducebusinesses’ confidence to make UK investment and supply decisions.


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The automotive sector is fast-moving and maintaining high levels of investment intechnology, design, and production is critical to keep it competitive. Many majorcar firms operating in the UK have plants across Europe, 65 with each competingfor investment and production. Currently, the UK automotive industry attracts

substantial inward investment due to its productivity. 66 Even a temporary decline ininvestment and connectivity in the UK automotive industry would therefore be arisk to the competitiveness and jobs in the sector. This is highlighted by GKN, aleading UK automotive and aerospace parts supplier, who warn that “over time aUK outside the EU will be disadvantaged and will lose the investment it needs tomaintain our industries.” 67

Process 4: Changing the UK’s domestic regulatory and legislative framework

1.50 The UK’s economic policy, regulatory and legislative framework would need to

reflect the outcome of all of the processes discussed above. Withdrawal from the EUwould involve considerable implications for UK domestic legislation. The UKParliament and devolved administrations would need to consider how to replaceEU laws, including how to maintain a robust legal and regulatory frameworkwhere that had previously depended on EU laws.

1.51 A recent House of Lords European Union Committee report on the process forwithdrawing from the EU concluded this would be a lengthy process: “Domesticdisentanglement from EU law would require a review of the entire corpus of EU law asit applies nationally and in the devolved nations. Such a review would take yearsto complete.” 68

56 Facts and Figures 2016, ADS (16 May 2016).57 2014 Annual Business Survey , Office for National Statistics (2015).58

Department for Business, Innovation & Skills (BIS) estimate for 2014 based on Workforce Jobs ,Office for National Statistics (2015).59 ‘ADS members are clear: remaining part of the EU is better for business’ , ADS (3 April 2016).60 ‘Airbus warns workers on consequences of Brexit’, Financial Times (4 April 2016).61 2015 Production Statistics, International Organisation of Motor Vehicle Manufacturers (OICA) (2016).62 SMMT (2016).63 BIS estimate for 2014 based on Workforce Jobs , Office for National Statistics (2015).64 SMMT (2016).65 Many UK producers have factories across Europe – for details see Automobile Assembly and Engine

Production Plants in Europe , European Automobile Manufacturers Association (ACEA).66 UK Automotive International Competitiveness Report 2015 , Automotive Council UK (2015).67 Remaining in Europe best for our business, SMMT members reveal in new survey, SMMT (2016).68 The process of withdrawing from the European Union , House of Lords European Union

Committee (2016).


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Box 1.D Impact of a decision to leave the EU on the financialservices sector

UK financial services firms would face costly upheaval in the event of a vote toleave the EU. Over 5,000 UK firms, including banks, investment firms andinsurance companies, hold passports which enable them to provide their financialservices and establish branches in other EU member states. 69

No existing alternative to EU membership, apart from EEA membership, preservesaccess to the passport, and EEA membership requires accepting the freemovement of people and making contributions to the EU. Cross-border businesswould therefore be subject to decisions by individual member state regulators orEU institutions.

In order to continue trading across the Single Market firms could have torestructure themselves. This could include creating or reconfiguring subsidiaries in

EU member states which, by being located in the remaining EU, would haveaccess to the passport. Such actions would involve relocating activities and jobsto the remaining EU. Restructuring businesses and relocating staff would take aconsiderable time. Securing a banking licence in some member states can takesix months to a year, and the further tasks associated with relocating operationscan take much longer than this. 70

It would be rational for firms to plan their response, soon after a vote to leave, toensure they could continue to provide services to their EU clients. Firms wouldneed to put their plans into effect before the final deal on the UK’s new tradingrelationship with the EU was known.

The relocation of financial services activities and staff outside of the UK wouldhave an immediate negative impact on jobs, exports and tax revenue. It could alsodamage the UK’s successful financial services clusters, which rely on theconcentration of financial services firms in cities including Belfast, Birmingham,Cardiff, Edinburgh, Leeds, London and Manchester. The relocation of somefinancial services activities could also have wider negative consequences for otherfirms and activities, such as professional and business services, that areassociated with the UK’s financial centres.

There are over one million jobs within the financial services sector. 71 Around two-thirds of jobs in the sector are based outside London, including 85,000 people in

Scotland and 98,000 people in the North West.72

Around 285,000 jobs are linkedto financial and insurance services exports to the EU. 73 If the UK left the EU thentens of thousands of jobs in the sector would be at risk. 74

69 Tracey McDermott, Financial Conduct Authority Acting Chief Executive, at The economic andfinancial costs and benefits of UK’s EU membership hearing, Treasury Select Committee (3 February2016).

70 In the euro area an application for a licence is jointly assessed by the European Central Bank andnational supervisors.

71 Workforce jobs by region and industry, 2015 Q4 , Office for National Statistics (March 2016). 72 ibid.


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Interdependencies of the four processes

1.52 Each of these four processes would be complicated in their own right, butconducting them all at the same time, on any terms that would be acceptable to theUK and within the specified two-year period for leaving the EU would almost certainlybe impossible.

1.53 As set out above there is no requirement for the process to agree any newarrangement with the EU to be concluded at the same time as leaving the EU. Indeed,the remaining EU member states could insist that the terms of the UK’s withdrawal areagreed before starting negotiations on the new relationship.

1.54 There would be a trade-off between securing a deal as quickly as possibleto reduce uncertainty in the short term and securing the best possible deal for theUK to minimise the economic costs of exit over the long term. Figure 1.B sets outthe interactions between the four processes. Case 1 of Figure 1.B shows completingthe withdrawal agreement and agreeing the new EU relationship before the end of the

two-year period.1.55 In the circumstances where it was not possible to conclude a newagreement with the EU within the two-year period, the UK would have to decidewhether to seek to extend UK membership of the EU until a new agreement hadbeen reached, or to accept exit at that point.

1.56 Extending the Article 50 process would require the unanimous approval of theEuropean Council. One or more of the remaining member states might expect the UKto offer concessions in return, such as that the UK’s rebate would cease automaticallyto apply. Case 2 of Figure 1.B shows what would happen if the Article 50 process wereto be extended beyond the two-year period.

1.57 UK withdrawal from the EU without an extension would mean entering aperiod of limbo, where the UK’s relationship with the EU would default to WTOrules. That period could last a number of years, with uncertainty over how long it wouldlast and what the final relationship would turn out to be. Case 3 of Figure 1.B showswhat would happen if the UK exited at the end of the two-year period without a newrelationship agreed with the EU.

1.58 In these circumstances, there would be a difficult trade-off for the UK over thelevel to set import tariffs. If tariffs were kept at zero with EU countries, the UK wouldhave to lower tariffs unilaterally with all other WTO members where it did not have apreferential trade agreement. As a result, the UK would give up a key bargaining

position in negotiating new trade arrangements. The alternative would be to raise tariffs

73 HM Treasury analysis using the methodology behind Box 1.J of HM Treasury analysis: the long-termeconomic impact of EU membership and the alternatives, HM Government (April 2016). Number of

regional jobs linked to EU exports, HM Treasury (March 2016). 74 3.4% of workforce jobs are in financial services, including insurance services. If it is assumed that the

sector maintains a constant share of UK workforce jobs then, as a share of the increase inunemployment relative to a vote to remain in the EU, this would suggest there would be around18,000 fewer jobs in the sector in the shock scenario and around 28,000 fewer jobs in the sector inthe severe shock scenario. However, these scenarios do not explicitly consider the impact ofinternational financial services activity relocating away from the UK. Taking account of the likelihoodof financial services firms relocating jobs away from the UK, the total number of jobs at risk in thesector would be larger than the figures above. Workforce jobs by region and industry, 2015 Q4, Office for National Statistics (March 2016).


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Figure 1.B: The interdependencies of the four processes triggered by a vote toleave the EU

Source: HM Treasury


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Section 2Macroeconomic analysis of theimmediate impact of leaving the EU onthe UK economy

Part 1: Introduction

2.1 A vote to leave the European Union (EU) would be an immediate andprofound shock. There would be a sharp rise in uncertainty, households andbusinesses would start to make spending decisions to reflect their expectations of lowerincomes in the future, and financial conditions would tighten.

2.2 The modelling approach to assess the impact of leaving the EU reflects three keyeffects, as described in Section 1. It analyses the implications of the United Kingdom(UK) starting to transition to a less open, less productive and permanently poorereconomy (the ‘transition effect’), as discussed in HM Government’s document, HMTreasury analysis: the long-term economic impact of EU membership and the

alternatives (“the long-term document”). 1 It also analyses the impact of the sharpincrease in uncertainty (the ‘uncertainty effect’) following the shock of a vote to leave theEU through a widely-accepted approach, building on methods used by Bank ofEngland and other leading economic researchers. Finally, it analyses how these effectsand the ensuing weakness of the economy are amplified by financial markets (the‘financial conditions effect’).

2.3 The comprehensive and rigorous modelling is informed by empirical analysis,external studies, and the evidence on the impact that these effects are already having, inorder to estimate the impact on a range of key economic variables. This document hasbenefitted from a review by Professor Sir Charles Bean, former Deputy Governor of theBank of England, acting in a personal capacity as an academic consultant to HM Treasury.

2.4 The analysis in this document estimates the impact of this adjustment on a rangeof key variables within the two years following a vote to leave the EU. This time framecovers the initial period available to complete the Article 50 withdrawal process (the left-hand side of Figure 1.B). The evolution of economic instability and disruption would bedetermined by the outcomes of complex and interdependent negotiations and policy

1 HM Treasury analysis: the long-term economic impact of EU membership and the alternatives , HMGovernment(April 2016).


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decisions. The modelling approach is set out in Part 2 and discussed in more detail in Annex A.

2.5 The analytical approach uses scenarios relative to a baseline of staying inthe EU. In doing so, the analysis of the immediate impact of a vote to leave canbe isolated from the many future complex and interdependent policy choices andnegotiations which would follow a vote to leave the EU. This is consistent with theexplicit focus in this document of modelling the impact of heightened instability anddisruption in the two years following the shock of a vote to leave, rather than trying toproduce a forecast of the UK economy by attempting to anticipate the outcome ofnumerous policy decisions and negotiations. 2 Beyond this point, the degree of instabilitywould depend heavily on the outcomes of these processes and negotiations.

2.6 The analysis in Part 3 presents two quantitative scenarios: a ‘shock scenario’and a ‘severe shock scenario’. The shock scenario makes a number of cautiousassumptions about the size of each of the main effects. The severe shock scenario actsas a sensitivity analysis, to test the cautious assumptions made in the shock scenario.In both the shock and severe shock scenarios, it is assumed that uncertainty would beelevated throughout the two-year period examined in this analysis. In the shockscenario there is a rise in uncertainty, tightening in financial conditions, and a fall inbusiness and household spending reflecting lower future productivity and incomes,using many cautious assumptions.

2.7 There is a plausible risk that the immediate economic impact from a vote to leavethe EU could be significantly worse. Therefore, a severe shock scenario is alsopresented in which the process for leaving the EU and redefining its economicrelationship exacerbates and extends the uncertainty and financial stresses, and soworsens expectations for the UK’s long-term economic outlook. This could reflect a

decision not to seek participation in the Single Market. 2.8 There are a number of downside risks that are not reflected in eitherscenario. Part 3, therefore, also discusses how more adverse developments mightresult in significantly worse economic outcomes, through triggering ‘tipping points’ suchas the crystallisation of financial stability risks, a ‘sudden stop’ to the external financingof the UK current-account deficit, or a tightening in monetary or fiscal policy in responseto a loss in the credibility of the UK authorities.

2.9 As noted in Section 1, each of the four processes that would need to becompleted to leave the EU would be complicated in their own right. Butconducting them all at the same time, on any terms that would be acceptable tothe UK and within the specified two-year period for leaving the EU, would almostcertainly be impossible. Part 3 then sets out how multiple shocks could result in morepersistent disruption and instability that continues to impact the economy beyond thetwo years examined in the scenarios.

2 A scenario approach is taken by the OECD and National Institute of Economic and Social Researchto analyse the economic impact on the UK of a vote to leave the EU. The Economic Consequences

of Brexit: A Taxing Decision , OECD (2016). The short-term economic impact of leaving the EU ,National Institute of Economic and Social Research (2016). HM Treasury took this approach toanalysing scenarios for a change of regime in its assessment of joining the euro. UK membership ofthe single currency: An assessment of the five tests , HM Treasury (2003).


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Part 2: Modelling approach

2.10 To model the impact on the UK economy of the instability created by a vote to

leave, the analytical steps taken by this document are: assessing the transition effect : analysing the short-term effects of

expectations of reduced trade, foreign direct investment (FDI), and productivityin the long term

assessing the uncertainty effect : constructing an indicator of uncertainty, andthen estimating the relationship between uncertainty and a set of economicvariables. Using this estimated relationship, a set of economic outcomes arecalibrated to reflect heightened uncertainty

assessing the financial conditions effect : analysing how the uncertainty,transition shocks and ensuing weakness of the economy are amplified byfinancial market volatility and asset price falls

modelling the overall impact : using a general equilibrium economic model toestimate the transmission of the transition, uncertainty and financial conditionseffects on demand, supply and asset prices

2.11 These steps are summarised in Figure 2.A.

Figure 2.A: Modelling framework

Assess ing the transit ion effect2.12 The Bank of England has said that following a vote to leave, “activity may also beaffected by concerns that the outcome might reduce the openness of the UK economy


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and its long-run potential supply”. 3 A proportion of the long-term impacts of the reducedopenness described in the long-term document would emerge in the short term. Thiseffect is a key input to this analysis to ensure it is comprehensive.

2.13 As set out in the analysis in the long-term document and Table 2.A, the UK wouldbe permanently poorer if it left the EU and adopted any of the models discussed. Thelong-term economic impact would reflect lower productivity due to reduced trade andfinancial openness and a small persistent effect from the short-term economic disruption.

Table 2.A: Annual impact of leaving the EU on the UK after 15 years (difference from being in the EU)

EEANegotiated bilateral

agreementWTO

GDP level (%) – central -3.8 -6.2 -7.5

GDP level (%) -3.4 to -4.3 -4.6 to -7.8 -5.4 to -9.5

Source: HM Treasury analysis: the long-term economic impact of EU membership, HM Government(April 2016).2.14 The scale of the short-term impact of this transition to a permanentreduction in trade, FDI and productivity would depend crucially on the sort ofrelationship the UK seeks with the EU.

2.15 Reflecting the shock of a vote to leave, there are likely to be immediateconsequences to reflect the adjustment to becoming permanently poorer in the longterm, particularly in financial markets. Businesses and households would start to adjustto being permanently poorer in the future by reducing spending immediately. For somebusinesses and households, this effect may only take hold over time as the difficult

negotiations begin and it becomes evident that the outcome will lead to a UK economythat is less open to trade and investment.

2.16 The modelling of both scenarios assumes that these impacts would buildup over 15 years from the time of a vote to leave the EU. The analysis in the long-term document was modelled over a period of 15 years, which is considered to be asufficient time horizon for the UK’s future relationship with the EU to be clear and theeconomy to have adjusted to a new ‘steady-state’ outside of the EU.

2.17 The size of these effects on trade, FDI and productivity in the shock scenarioreflect the transition to the central estimate of the negotiated bilateral agreementalternative. As set out in the long-term document, leaving the EU under this alternative

would result in Gross Domestic Product (GDP) per household being £4,300 lower everyyear after 15 years, than if the UK remained in the EU.

2.18 The severe shock scenario is characterised by larger effects on trade, FDI andproductivity to reflect the transition to the central estimate of an external relationship basedon WTO membership. This could reflect a decision to be outside the Single Market.

Assessing the uncertainty effect2.19 A large number of existing empirical studies on the impact of uncertainty evaluatethe economic response to select uncertainty measures, including implied volatility in

3 Inflation Report May 2016 , Bank of England (2016).


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financial markets, consumer and business survey data and forecast dispersion. 4 However, no single uncertainty measure is likely to capture effectively uncertainty acrossthe economy and over different economic episodes. For the purpose of this analysis, acomprehensive UK uncertainty indicator is constructed by averaging six measures ofuncertainty in order to estimate the size of uncertainty shocks in past episodes. 5 The

Bank of England has also used a similar composite uncertainty indicator

Documents

HM Treasury Analysis – The Immediate Economic Impact of Leaving the EU